The first step in calculating the R&D Tax Credit is to determine the business's Qualified Research Expenditure (QRE) in the tax year. This is the primary objective of an R&D Study. In order to make that determination, businesses often look to their accounting group or an outside provider to help them determine how much Qualified Research Activity the businesses engaged in during the year. (Side note: The firm in charge of the R&D Study will compile their findings into documentation that will be used to defend their tax credit if the business is audited by the IRS in the future. More on the documentation process later.)
There are two ways to calculate the R&D Tax Credit: the Regular Credit method and the Alternative Simplified Credit (ASC) method. The credit's formal name is the Credit for Increasing Research Activities, and in both methods, the relative size of your credit will depend on the extent to which your current year QRE exceeded your previous year(s) QRE.
Because W-2 Wages and 1099 Contractor expenses make up over 84% of QRE across all industries (IRS data, 2014), year-over-year engineering team (or similarly, investment in engineering) growth is often a primary determinant of the size of the tax credit in a given year. Of course, that's not always the case, but it's a good rule of thumb.
The Regular Credit method is complicated and often used to calculate the credit for much older companies. Most startups and early-stage companies use the ASC method, so that's what we'll focus on here.
The Alternative Simplified Credit (ASC)
To calculate QRE using the Alternative Simplified Credit method:
First, determine the average QRE from the last three years.*
Multiply that average by 50%.
Subtract that amount from your current year QRE.
Multiply the remainder by 14% and you have your current year R&D Tax Credit.
*If there were no QREs in any previous tax years, calculate the current year's QRE and multiply be 6%. This is your first-year R&D Tax Credit.
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